EMC Q2 2007 Earnings Call Transcript

Jul.24.07 | About: EMC Corporation (EMC)
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EMC Corporation (NYSE:EMC)

Q2 2007 Earnings Call

July 24, 2007 8:30 am ET

Executives

Tony Takzawa - VP, IR

David Goulden - EVP & CFO

Joe Tucci - Chairman, President & CEO

Analysts

Aaron Rakers - A.G. Edwards

Laura Conigliaro - Goldman Sachs

Shebly Seyrafi - Caris & Co.

Keith Bachman - Bank of Montreal

Bill Shope - J.P. Morgan

Andrew Neff - Bear Stearns

Katie Huberty - Morgan Stanley

Dan Renouard - Robert W. Baird

Harry Blount - Lehman Brothers

Bill Fearnley - FTN Midwest

Clay Sumner - FBR

Ben Reitzes - UBS

Tom Curlin - RBC Capital Markets

Glenn Hanus - Needham & Co.

Toni Sacconaghi - Sanford Bernstein

Presentation

Operator

Welcome to today's EMC conference call, the second-quarter earnings conference call. All lines will be in a lesson only fashion until the question-and-answer portion. As a reminder, today's conference is being recorded; if anyone has any objections you may disconnect at this time. I'd now like to turn the call over to today's host, Mr. Tony Takzawa. Sir, you may begin.

Tony Takzawa

Thank you, Lisa. Good morning. Welcome to EMC's call to discuss our financial results for the second quarter of 2007. Today we are joined by Joe Tucci, EMC Chairman, President and CEO, and David Goulden, EMC Executive Vice President and CFO. David will start things off by walking you through EMC's activities and financial results for the quarter. Joe Tucci will then spend some time discussing his market outlook, EMC's execution of the strategy and the progress we are making toward our annual goals. After the prepared remarks we will then open up the lines to take your questions.

Today's slides contain important information that is necessary to understand our results and commentary, so we encourage you to view them on EMC's website at EMC.com. An archive of the audio and slide presentation will also be available following the call.

As always, the call this morning will contain forward-looking statements. Information concerning factors that could cause actual results to differ can be found in EMC's filings with the U.S. Securities and Exchange Commission. In addition, all the numbers we discuss today will be presented on a GAAP the basis unless otherwise indicated. For those of you interested in analyzing the non-GAAP numbers, we continue to provide a schedule in the press release that will help you adjust the GAAP results for stock option, restricted stock and amortization expenses.

Lastly, I do want to point out that given VMware's spending IPO, our commentary on VMware's 2Q results is limited to what is in today's earnings release. In other words, we will not be able to provide additional commentary or color on VMware's business or financial results at this time. With that it is now my pleasure to introduce David Goulden. David?

David Goulden

Thank you, Tony. Good morning and thank you for joining us today. We are pleased with our Q2 operational and financial results. We demonstrated crisp execution, delivered strong performance in a number of key areas and made great progress towards our goals for the year.

Turning to the numbers. Q2 revenues were $3.12 billion, up 21% from Q2 of last year; earnings per share were $0.16, up 33% over Q2 of last year; and free cash flow was $422 million, up 123% from Q2 last year. I'll now walk you through the results in a little more detail.

Q2 revenue growth of 21% over last year included approximately 200 basis points held from currency. Looking first at our corporate revenue mix compared to a year ago, systems revenues were up 18% with strong midrange growth, software revenues were up 27% led by RSA Security and VMware, and services revenues were up 18% driven by strong double-digit services growth in all four business segments.

Now turning to revenue by geography, I'm pleased to report we had 20% plus growth in each of our three largest geographies. Revenues from North America grew 20%; a significant highlight in this region for Q2 and for the first half is the growth in the commercial market segment. EMEA revenues were up 21%; CLARiiON, IP storage and CMA did well in these markets. APJ had another great quarter with revenues up 32% over last year. This is the second quarter of revenue growth over 25% in APJ and demonstrates we're gaining share in this important market.

This quarter we continue to strengthen our senior APJ management team and we are pleased that a very seasoned technology executive from Fujitsu, Soshio Marihoshi (ph), recently joined us as our new Country Manager for Japan. The strong leadership and execution from our management team coupled with investments we've made in this region are already translating into strong results. And finally, Latin American revenues were up 16% which is a nice bounce back from Q1.

Next I'd like to cover the revenue results from each of our four business segments -- information storage, content management and archiving, RSA information security and VMware. These segments represent the major markets we focus on within IT, the solution sets we bring to customers and reflect how we run the business.

First let's take a look at our information storage business. Total storage revenues for Q2 were $2.5 billion, up 12% over Q2 last year. Within the storage business Symmetrix revenues were up 3% year-on-year against, as you will recall, a relatively easy compare. We realize that many of you will be trying to normalize last year's Q2 and Q3 Sym revenues in your analysis and it should help you to know that Sym bookings were flat year-on-year against a tough Q2 bookings compare.

We're particularly pleased to see the solid demand ahead of the new DMX-4 announcement. We had a great quarter in our midrange business with CLARiiON revenues up 34%. We were very pleased with this growth both domestically and internationally. We continue to see the adoption of backup to disk strengthening and our disk leverage products had a great growth again this quarter.

Storage services grew double-digits lead by strong growth in our backup recovery and archive practice and our Microsoft practice. Dell represented 15.6% of EMC's total revenue this quarter; within this total Dell was a little over 35% of CLARiiON revenues and the balance came from a broad mix of information storage and VMware products.

In summary, Q2 was a solid quarter in storage for EMC with good revenue growth and sequential improvement in margins. Looking ahead we continue to expand the breadth and depth of our storage product portfolio and we announced several important products last week. These products reflect the strategic focus of our R&D efforts as we continue to deliver market leading solutions for customers' traditional performance and availability requirements. And we're also now leading the market for customers' rapidly emerging requirements for security, tiering, consolidation, ease-of-use and energy efficiency.

In addition to new product development, we're also driving deeper integration of many of our acquired technologies across our products to provide solutions that no one else offers. A few recent technology integration examples that expand our unique storage offerings include the addition of RSA authentication authorization and audit capabilities into Symmetrix, Avamar backup and data de-duplication technology optimized with VMware and Solaris NAS platforms and the integration of RecoverPoint replication technology we acquired with Kashya with our CLARiiON, Connectrix and Invista storage products.

According to recent surveys, storage remains a top spending priority with CIOs. We estimated at the beginning of year that the storage market will grow about 8% in 2007 and this appears to be on track. The demand for the differentiated products and services we offer gives us confidence that we're well positioned for continued growth and share gains in storage this year.

Turning now to our content management and archiving software business. Total revenues were $174 million, up approximately 5% over last year. License revenues continue to be lumpy and we're down 8% against a very tough compare to Q2 last year. Maintenance and professional services revenues were up 18% year-on-year reflecting the effect of last year's strong growth in this business.

I want to touch on two factors that impacted this quarter's CMA results. First, in the middle of the quarter we internally announced and began implementing some changes to our CMA go to market model. These changes are now complete and will result in more dedication and focus on content management. And we're also seeing some effects from the rapid consolidation that has taken place in this market. We believe the changing competitive landscape has caused some near-term purchase pause with customers.

Taking these factors into account our Q2 results were pretty much in line with our internal expectations. Looking ahead there are some key factors that give us confidence in our CMA business in the second half. First, our business pipeline is strong. Second, we've now implemented our go to market enhancements and we've strengthened our partnerships with several of the leading global systems integrators. And third, we are very confidence in the competitiveness of our product portfolio and our technology leadership in CMA.

Next week we are excited to be launching our new D6 platform; the next generation Documentum D6 platform will raise the bar for content management and archiving solutions. For the year we now expect the CMA market to grow around 10%, similar to last year's growth rates. We continue to be confident we'll post solid results for the year.

Now let me turn to the RSA information security business, revenues in Q2 were $125 million and on a comparable basis if we had owned the business last Q2 revenues were up 21%. RSA helped to accelerated EMC's overall Q2 revenue growth by approximately 490 basis points. Our RSA information security business has achieved 20% plus year-on-year growth every quarter we've owned it, which validates the strategic focus of this business and demonstrates solid execution.

RSA SecureID continues to do well and we're also seeing very strong traction for RSA's consumer protection, encryption and key management solutions. We recently expanded our leadership in the consumer protection business with the acquisition of Verid. Verid's knowledge-based authentication is a powerful extension of RSA's leading consumer identification solution.

In other Q2 developments we announced a partnership with Cisco to develop technology that will help customers encrypt data arrest on tapes and other types of storage media and manage the associate encryption keys. Looking ahead, we continue to believe the security market we address will grow approximately 17% this year and we expect to continue to take share.

VMware had another quarter of record revenues, up 89% from last year to $289 million. This rate of growth is fueled by the continued demand VMware is experiencing for its virtualization offerings. As I'm sure you saw, we filed a second amendment of the S1 on July 9th that included an initial pricing range and details of the share exchange offer for VMware employees. It also contained details of the sale of a 2.5% interest in VMware to Intel. Intel's investment in VMware is intended to foster strengthening collaboration, accelerate VMware's virtualization product adoption upon interarchitecture and reinforce the value of virtualization technology for customers.

The Intel investment coupled with a partial IPO will result in 12.5% of VMware being owned by third parties. This morning we will be filing our third S1 amendment in response to comments we received from the SEC on amendment number two. We continue to be on track to complete the partial IPO of VMware this summer and we'll start the IPO roadshow as soon as we're clear to do so by the SEC.

In summary, we are pleased with the aggregate revenue results from our business units this quarter. We continue to believe we're focused on the right markets and have the best information infrastructure solutions to help customers address their most critical information management priorities.

Turning now to the rest of the income statements -- gross margins were up 170 basis points year-on-year and up 160 basis points from Q1. year-on-year improvements were driven by software mix and also by improvements in services margins. The quarter-on-quarter sequential margin improvement was driven principally by the bounce back in the mix of our storage hardware products and also by the increase of software revenues as a percentage of total revenue.

Q2 operating margin was up 220 basis points over last year and 100 basis points sequentially from Q1. Operating expenses as a percentage of revenue increased slightly sequentially. This increase reflects the growing contribution from the security, content and VMware businesses. These businesses have higher gross margins and also have higher operating expenses compared to storage business.

In Q2 we continued with our integration plans to improve efficiencies across the Company's business and reduce costs whilst helping us to present a more unified one EMC experience to our customers. We now are about halfway towards completing the Q4 '06 restructuring plan. Net-net we are pleased with our operating margin improvement this quarter and continue to be focused on our cost base, expense management, and driving operating leverage.

Finally, our reported tax rate for Q2 was approximately 22%, which included a few small onetime benefits. Without these benefits, the Q2 tax rate would have been 23%, which is similar to last quarter.

Turning to cash flow, cash from operating activities in Q2 was $622 million, up 59% from Q2 last year. This improvement came primarily from our increased pretax income, growth in deferred revenues and the decrease in income taxes paid. Looking at other balance sheet metrics that impact operating cash flow, DSO's were 49 and inventory turns were 6.9.

Q2 free cash flow was $422 million, up 123% from Q2 last year. CapEx was $154 million which is flat from Q2 last year. This includes our continued investment in VMware's new headquarters which we anticipate completing this summer. We should see continued declines in CapEx throughout the balance of the year. Software capitalization costs per quarter were $46 million.

Now turning to cash use. We spent $390 million to buy back approximately 26 million shares in Q2. The average diluted share account for the quarter was 2.122 billion. Year-to-date we've spent $878 million to buy back approximately 61 million shares. This puts us most of the way towards our stated goal of at least $1 billion of share repurchases this year. We have 79 million shares remaining in our repurchase authorization. Additionally, we continue to expect to allocate a portion of the proceeds from the VMware IPO towards returning value to EMC's shareholders.

We spent $158 million on acquisitions for our security and VMware businesses in Q2 and we ended the quarter with cash and investments of approximately $5.9 billion, up slightly from Q1, nearly half of this is held in our overseas operations and in VMware.

Now I'd like to make a comment on our capital structure planning. We believe our recent capital structure initiatives, including the convertible debt transaction and share buybacks, have been very beneficial for shareholders and obviously the next major capital structure development is the forthcoming partial IPO of VMware. While we're currently evaluating additional initiatives, we want to complete the VMware offering first so we can make more informed decisions about the best course of action to take next.

Looking ahead, and based upon our results for the first half and our expectations for the rest of the year, we believe that we're now on track to exceed the annual targets we set in January of $12.7 billion of revenue and $0.64 of earnings per share. We still expect our quarterly revenue progression in 2007 to follow normal seasonal patterns. To recap what we said in January, this means a typical progression of revenues throughout the year with Q1 being seasonally lower than the prior Q4, Q2 being a step up from Q1, Q3 having broadly similar revenues to Q2 and Q4 being the strongest revenue quarter. With that I will turn the call over to Joe.

Joe Tucci

Thanks, David. Hello and welcome to all of you participating in our Q2 conference call today and thank you very much for joining us. Overall Q2 represented another solid quarter for EMC. The pace of business throughout the quarter was good. We pretty much stayed on our calendarization plan from both a bookings and revenue flow point of view. And this was true in all three tiers of operations -- the Americas, APJ and Europe-Africa-Middle East.

In the Americas I am pleased to report that we saw some pick up in spending in U.S. enterprise accounts over Q1. And I am very happy to report that our Asia-Pac business again produced strong results reflecting the focus and dedication of our new management team in this important high-growth region of the world. In fact, I'm externally proud of how the entire EMC team in all parts of the world and all disciplines has been executing our strategy and driving results. I want to thank everyone at EMC for their hard work and support of our valued customers.

Looking quickly at the IT spending outlook for 2007, we see a positive environment in all major geographies and we believe there is opportunity for us to beat our annual financial targets for revenue, earnings per share and cash flow. EMC's positive results and momentum are obviously only possible because customers are embracing our strategy, our leading products, our services and our solution sets at each of our four businesses -- storage, content management and archiving, RSA security and VMware. So let's look forward a bit of touch on each of EMC's four business units and their growth initiatives. I'll start with our storage business.

EMC is a technology company and a lifeblood for any technology company is the constant flow of innovative leading best of breed products and when I look at EMC's storage business for the second half of this year we indeed have the advantage of a very strong new product cycle which we launched last Monday. At this launch we announced the next generation Symmetrix, DMX-4. As our customers in the market have come to expect from EMC's Symmetrix platforms, DMX-4 leads the market in scalability, performance and functionality and it will set a new benchmark for reliability in storage platforms.

Additionally the new DMX-4 adds leading capabilities for high end storage platforms in areas of power efficiency and ease-of-use features. And without a doubt, thanks to our integration with RSA security technology, the DMX-4 is the industry's most secure storage platform.

Also very prominent at last Monday's new product launch was our focus on the mid-tier and low end storage market. EMC is clearly focused on going down market into the commercial and SMB segments. This was evidenced by CLARiiON's -- the X3's year-over-year growth of 34%. We have a strong mid-tier product portfolio underpinned by five-nines of availability that is being well-received by customers.

To further strengthen our position in the mid-tier and low end storage markets EMC announced two brand-new game changing multiprotocol arrays -- the NS40 and the NS20. A multiprotocol array is an array which can support fiber Channel Sans, ISCSI sans and network attached storage separately or concurrently. A multiprotocol array also provides for tiering of storage in the box by utilizing both high-speed fiber channel drives and high-capacity, slower less expense serial ATA drives simultaneously. Collectively these features give customers excellent price performance and tremendous flexibility.

The NS40's and the NX20's feature list is very rich. For instance, they support up to 1000 snaps; they support iSCSI remote replication allowing for connection in lower cost ports; they have thrift in provisioning with important safety features built-in; they have advanced security and compliance features; they feature RAID 6; they have five-nines of availability; and its ease-of-use features are second to none and I could go on and on with this list of features.

Obviously based on our Q2 results we have a lot of momentum in the mid-tier market. In addition, with these new multiprotocol systems, which will undoubtedly put heat on our traditional mid- and low-tier storage competitors, and on a number of storage startups that have been attempting to make noise lately in the marketplace.

Lastly in the storage archive market we announced the next generation of our successful Centera platform. The new generation four Centera system uses 67% less power and stores 50% more data. So I think you have a feel for why I believe the EMC storage business has the advantage of a strong product cycle going forward.

Turning to our RSA security business, RSA has continued to outpace the growth of the market with more than 20% year-over-year growth. Information security continues to remain at or close to the top of our customers' IT spending priorities, and I expect this trend to continue far into the future.

RSA's continued strong growth was in part due to its significant success in Payment Card Industry Data Security Standards, PCI DSS. And also very notable, a demand across multiple industries for stronger authentication requirements. Less than a year after the RSA acquisition the payoff is playing out through its growth in the storage security market and in the security market itself.

In secure storage and information management we're driving RSA security through our complete product portfolio and last quarter's acquisitions of RSA into EMC storage was an example and also outside of EMC we also drove some RSA technologies with Cisco into some of their products. So we have good momentum here.

Next, let's look at our content management and archiving business unit. We are definitely not executing to our full potential in this market. The content management archiving business faced an abnormally tough year-over-year compare this quarter. Just to remind you, last year in Q2 CMA posted a very high double-digit growth year-over-year revenue rate of 52%. Added to that the mid-quarter sales realignment, which we did that David alluded to, increased the degree of difficulty and ended up temporarily handicapping our execution in the quarter. But that's no excuse; we can and we will do better and you will see better execution from us in this business.

Despite these challenges the EMC Documentum platform continued to rack up industry accolades, including E -DOC magazine's reader's choice award and ECM Connection Ace award. And we're starting out Q3 on a good foot. Just last week Forrester positioned EMC as the leader in the Forrester Wave for business process management.

Earlier I spoke of the importance of new innovative product launches and to this end next week we will announce the next generation Documentum 6 platform which features revolutionary capabilities for application developers and a new Web services API. And to further assure we stay on the leading edge amid the widespread shift to XML, EMC also last week completed a small but relatively strategic and important acquisition of X-Hive, a Rotterdam based XML technology leader. I am confident that the products and solutions we have in place, along with our go to market realignment, will help us return to double-digit growth for CMA in the second half of this year.

On the services front we continued our tradition of helping customers get the absolute most from their investments in the information infrastructure technologies. Services posted a healthy 18% growth. EMC's core service offerings, coupled with a strong (inaudible) of service, technology and distribution partners, is a powerful combination for customers. Our application focused solutions approach worked with partners like Microsoft, Oracle and SAP has allowed us to address application infrastructure issues for our customers and has expanded our opportunity.

Turning now to VMware, as you know, we're going to sell 10% of VMware to the public. And as David said, we are very active in the registration statement process, so I will not make any very succinct forward-looking statements, but I do want to point out that I am incredibly pleased with the rapid growth and adoption of customers of VMware Virtual Infrastructure strategy and I continue to see great potential for this platform. And it goes without saying that I'm incredibly proud of the more than 3000 VMware people around the globe that are making this happen.

In closing, I'm excited about EMC's opportunities and prospects going forward. We are well positioned in several of the fastest-growing markets in IT. Our information infrastructure and virtual infrastructure strategies are being embraced by customers. We have solid momentum and you can feel the confidence in the people at EMC in our ability to execute. With that, let me turn it back to Tony for the Q&A portion of today's call. Tony?

Tony Takzawa

Thanks, Joe. Before we open up the lines for your questions, as usual we ask you to try and limit yourselves to one question; this will enable us to take as many questions as possible. Thank you all for your cooperation in this matter. Lisa, can we open up the lines for questions, please?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Aaron Rakers with A. G. Edwards.

Aaron Rakers - A.G. Edwards

Thanks, guys, and congratulations on a good quarter. I guess I'll just start by asking, David, how do you look at the cash position of the Company? I know you mentioned half of the cash tied up in terms of foreign jurisdictions and VMware. Can you help us understand about how much you need to manage the business? And what I'm really getting at is the potential for accelerated share repurchases looking into the back half of the year?

David Goulden

Aaron, thank you. I did mention that of the $5.9 billion, assume roughly half of that is either international or in VMware, so it's not readily assessable. Obviously that leaves half of it sitting in the domestic side of the business. And as we mentioned before, we really made about $1 billion of float to run the business domestically. So as we're looking forward amounts over that are of course available for us to either reinvest in the business, do acquisitions or to potentially return to shareholders which, as I mentioned, we're looking at, but nothing more on that front until we've completed the IPO.

Tony Takzawa

Thanks, Aaron. Next question, please.

Operator

Thank you. Our next question comes from Laura Conigliaro with Goldman Sachs.

Laura Conigliaro – Goldman Sachs

It’s great. You've had issues in the not too distant past with some product resets or refreshes. And you've got a whole bunch of newly announced products which won't be available until August. Can you talk about some of the measures you've put in place to help offset potential stalling, also to ensure good product availability in the back half of that quarter? And does this increase the risk or why doesn't this increase the risk in an already back end loaded quarter?

Joe Tucci

The major product transition, Laura, is in Symmetrix because if you look at the CLARiiON, the mid tier CX3 has been in place for a while now and, as you just saw, had rather exceptional performance. And the NS40 and NS20 that are sliding in there which we think are really game changing new arrays with these multiprotocol features, I don't think that's going to give us any issues at all.

So turning back to Sym, which is probably where your question ties from because be it a year ago Q2 we -- I'll be as blunt as I can -- we blew the transition because we had too many -- we had the orders, we had a good bookings quarter a year ago in Q2, but we blew the transition because we ran out of -- we guessed wrong, we had the DMX-3. So one of the things we're doing is obviously we're being a little more flexible in making sure we have a little bit of inventory. So we'll take some of the heat on the turn side to make sure that we have turn and I'm confident, just like I was last year. We didn't end up with excess inventory of DMX-2 so this will play out quite well.

The transition here is not as major. The DMX-3 to DMX-4, while it's got a totally new back end and some really good features, it's not as major because the DMX-3 was a total redo. So that was a more major transition. So the fact that this was kind of a not as major transition in the fact that we are keeping a little extra inventory and learned from our steps, we're pretty confident we've got it.

Tony Takzawa

Thank you, Laura. Next question, please.

Operator

Thank you. Our next question comes from Shebly Seyrafi with Caris & Co.

Shebly Seyrafi - Caris & Co

Yes. Nice quarter. Your CLARiiON growth, 3% to 4% year-to-year, I translate that to around 12% sequentially. Can you talk about what drove that? Are you gaining share from, for example, Network Appliance which is known to be struggling a little bit this quarter? Talk about the competitive landscape in the midrange? Thanks.

Joe Tucci

I think the two big players in the mid tier are obviously -- that we face are Network Appliance and HP. I think obviously the CX3, as we really have done a lot of work on the iSCSI side, Shebly, that's really I think helped us be much more effective in the marketplace. We came out with the CX3 model 10, so we lowered the entry price, CX3 model 10 effectively can start even a tick below 20,000. So we have a fuller line, a lot more iSCSI support and features. We put more focus on it with our buildouts of our channels.

Dell had a good quarter, as David indicated, as did many of our other channels. So it was just good overall performance and it's a good productline. And then of course we see now with these multiprotocol arrays coming out on top of this or in addition to this, we have a really powerful lineup for the mid tier and I feel very bullish. And as I said in my remarks, there's more to come because we're even going to come out with a low-end array in this family. So we're in good shape.

Shebly Seyrafi - Caris & Co

Thank you.

Tony Takzawa

Thanks, Shebly. Next question, please.

Operator

Thank you. Our next question comes from Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Good morning. Thank you. My question relates to, David or Joe, on the margin side -- very nice gross margins helped by mix. The other side is operating expenses were also up considerably driven by mix. So your operating expense actually grew on a year-to-year basis at the same rate of revenues. Does this continue -- that your operating expenses continue to grow at the same rate of revenues or do you think you can drive incremental operating margins as we look out over the next few quarters?

David Goulden

Keith, we're focused upon operating margin leverage. And as I said, there are a couple of things happening within the business. As our mix of revenues shifts more towards content security and VMware, those businesses compared to storage are carrying a higher gross margin and a higher operating expense to revenue. Year-on-year I'm not sure where you're getting operating expense increases from. We can maybe handle that off-line or on the call.

We're seeing decreases year-on-year in operating expenses. The increases I mentioned were sequential increases, 60 basis points, and that was almost entirely due to the mix shift which we spoke about. Again, the key thing to look at is our operating margin numbers which, as you saw, were up sequentially and year-on-year strongly.

Joe Tucci

If you break that apart year-on-year, Keith, there certainly was an 80 basis points decline in SG&A and then of course we had a little bit more than that, about a 70 basis points increase on percentage point in R&D. So as we become more -- we're investing a tremendous amount in VMware or say in other properties which you've got growth and has become 41% of our revenues this quarter was software. So as we go that way it drives up our R&D a little bit. And as David can say, we've got to watch all these numbers and there is opportunity there for sure.

Tony Takzawa

Thanks, Keith. Next question, please.

Operator

Thank you. Our next question comes from Bill Shope with J.P. Morgan.

Bill Shope - J.P. Morgan

I guess related to Keith's question as well, looking at the headcount reductions you announced last year, should we expect that to have more of an impact on OpEx in the second half or is it already starting to flow through the model? And also, can you comment on core EMC OpEx trends ex RSA and VMware as you did last quarter?

David Goulden

Bill, as we said before, the reduction -- the headcount reduction program will happen on a pre flat basis across the year. Which means that you can grow into the expenses -- you grow into the expense reductions as you go through the year and the people come out. In terms of if I look at -- last quarter I did make a comment year-on-year about operating expenses for the business without VMware and without security. And if you look at Q2 without VMware and without security, they're down significantly compared to a year ago. I gave you a number last quarter; I don't want to give you a number each quarter, but they were down a higher number on a percentage basis than they were last quarter.

Bill Shope - J.P. Morgan

Okay. Thank you.

Tony Takzawa

Thanks a lot, Bill. We'll take the next question, please.

Operator

Our next question comes from Andrew Neff with Bear Stearns.

Andrew Neff - Bear Stearns

Sure, this is a more technical question, but after the VMware transaction is completed can you take us through, David, how it will flow through your numbers, how you will reflect different things?

David Goulden

That is a technical question. But basically the short answer is that from a revenue gross margin, OpEx, expenses, everything gets consolidated. There will be a deconsolidation at the equity level on the balance sheet and also before net income for the minority interest that we do not hold. That's the easiest way to think about it. And we'll kind of walk you through all that in much more detail after the IPO when we start publishing that way so you understand exactly what's going on. But simply that's how it's going to work.

Andrew Neff - Bear Stearns

You'll show a minority interest line offsetting to reflect that -- what part you don't own essentially?

David Goulden

Exactly, that's right. That will flow through the income statement and it will be reflected on the balance sheet through equity.

Andrew Neff - Bear Stearns

But otherwise, from our modeling standpoint, above that it will be the same?

David Goulden

Above that, yes. UP through the operating margin, etc., it will be exactly the same.

Andrew Neff - Bear Stearns

Okay, great. Thanks.

Tony Takzawa

Thanks, Andy. Next question, please.

Operator

Thank you. Our next question comes from Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Thanks. Good morning. Joe, can you comment more on the strength you saw in the U.S. segment? Was it linear through the quarter or more front-end loaded as deals slip from March into April? And then perhaps touch on enterprise versus SMB segments in the U.S.

Joe Tucci

Yes, we have found that the SMB and the commercial segments have continued to be robust through (inaudible) -- we didn't see any kind of slowdown at all say last quarter for instance. It's been good for several years for us and continues to be very strong and opportunity rich for us. In the enterprise segment, as I said, we did see a bit of softness in Q1 and this quarter I'm glad to say that as we set out our linearity plan, which means we saw no -- it was pretty linear throughout the quarter. We saw a renewed strength in enterprise in the U.S. throughout the quarter and it was very linear, it wasn't spiky at all.

Tony Takzawa

Thanks, Katie. Next question, please.

Operator

Thank you. Our next question comes from Dan Renouard with Robert W. Baird.

Dan Renouard - Robert W. Baird

Thanks. Can you give us a little bit more detail on these new low-end products? More specifically, how you think about potential for cannibalization in the channel? And then also with Dell, is Dell out of the gate going to be selling those products? I'm talking about the 20 and the 40? Thanks.

Joe Tucci

I don't really care about cannibalization. It doesn't matter to me whether we sell CX or the multiprotocol, they're both our technology. Margins will be at the same level, so we're very benign on which of the products we sell. It's what fits the customer environment better and I think this is going to be a real strength of us. So the cannibalization issue is a non-factor. You asked about Dell and I'll let Dell speak for themselves, but I think you can count that they will resell some of the multiprotocol products.

Tony Takzawa

Thanks, Dan. Next question, please.

Operator

Thank you. Our next question comes from Harry Blount with Lehman Brothers.

Harry Blount - Lehman Brothers

Thanks. David, you had indicated in your prepared remarks that you would reevaluate the capital structure post VMware. I was hoping you could put a little more color on that in terms of things that you might consider, things that you would definitely not consider in terms of what the capital structure will look like.

Joe Tucci

I'm going to stick where David did, Harry, I'm not going to duck it. I assure you at a Board level there is nothing that is off the table; we are looking at every option to make sure that we are committed to return some cash to shareholders from this transaction, we will. As you know, there are several ways of doing that and the Board will evaluate each of those and I'm sure we'll pick the absolute best one. But we don't want to get there until after this IPO closes which David said we will start the roadshow as soon as we get the final approval from the SEC.

Tony Takzawa

Thanks, Harry. Next question, please.

Operator

Thank you. Our next question comes from Bill Fearnley with FTN Midwest.

Bill Fearnley - FTN Midwest

Yes, I wanted to ask if -- could you guys give some more color on trends you see in CLARiiON, Symmetrix regarding mix, deal size and near-term growth prospects? Thanks.

Joe Tucci

Growth prospects, the high-end market is a growth market that over the last several years has been in the mid single-digits and I really don't expect that to change. Now of course in 2005-2006 we were the clear leader. This first half of this year we slowed down. So this is very product cycle -- product cycles affect this significantly. Customers know when these product cycles are going to come. As I said, we have been a share gainer if you look back over the last two plus years. We think -- we know that DMX-4 is very well-positioned.

But that being said, that's where the growth in this market is, it's in the mid single-digits and it gets affected very much in terms of which player is growing or not growing at a particular point by product cycles. And as I said, we're now going into a very favorable product cycle, so obviously we would expect to take share. But that's just the texture and tenure of the market, Bill. Great market, great cash flow.

CLARiiON, this is a double-digit growth market and we want to considerably outpace the market growth and we think that with the CLARiiON and of course the multiprotocol is built on CLARiiON technology underneath it. So we expect these broader mid-tier platforms, CLARiiON or NS, we will considerably outpace the market and, as I said, with the NS I think we're incredibly well-positioned to really take on some of the tougher mid-tier competitors, maybe the toughest mid-tier competitor even. And of course incredibly well-positioned, I mean incredibly well-positioned against the startups.

Tony Takzawa

Thanks, Bill. Next question, please.

Operator

Thank you. Our next question comes from Clay Sumner with FBR.

Clay Sumner - FBR

Thanks very much. Within the storage group software license growth of 4% was a good bit less than systems growth. Can you just provide some color around the dynamics, the puts and takes within that storage software license number?

David Goulden

Yes, Clay, certainly. There are a couple of things happening there. As we said to you before, within that storage number there is platform software and there's software which is off the platform -- that would be resource management backup recovery software. And as we said going forward expect platform software to grow a little less than platform hardware because the move towards large end systems with a higher capacity, lower cost per megabyte and also towards lower-end systems which have less software content on them.

Having said that, offsetting that you'll see the relatively faster growth of resource management backup recovery software. So as the mix in storage software moves towards those second two categories more you'll start seeing those two lines get closer together from an overall growth point of view. And those are the basic dynamics happening in there.

Joe Tucci

You've got to remember, Clay, we have tremendous penetration of these software products specifically and mostly in our high-end storage arrays with Symmetrix. So customers have bought those licensed, they're expensible because the way we do it you pay a license and then you pay maintenance support which gives you additional upgrades.

So what happens is we've got such a great footprint in proliferation that it's hard to grow the license side of that. But if you looked at the support side of that, it's growing more than twice as fast as the license side. So if you look at it in total, it's a tremendously good cash flow business and one we're proud to have and one we use to fuel other things that we do. So if you look at the storage business as a whole, we will outpace the market.

Tony Takzawa

Thanks, Clay. Next question, please.

Operator

Thank you. Our next question comes from Ben Reitzes with UBS.

Ben Reitzes - UBS

Good morning. Thanks. You've generated about $1 billion in free cash flow already in six months and last year you did about $1.2 billion. Could you talk about what your free cash flow may look like for the year if you exceed your EPS targets like you're talking about? And also where you are on your free cash flow targets in terms of your compensation metrics which I believe now include quite a bit on free cash flow generation?

Joe Tucci

When you say quite a bit, the majority is still on EPS just so that you know that.

Ben Reitzes - UBS

Well, there should be something.

Joe Tucci

There is something, yes; it's meaningful. What I would give you too much insight here that could be harmful in the market. That is the metric we're the most ahead on as a management team. So our key free cash flow we're doing very well on. And obviously you know our metrics for EPS and revenue, we publish them.

Ben Reitzes - UBS

I guess the question is do you typically generate more free cash flow in the second half than the first half?

David Goulden

It depends upon a number of things including the timing of tax payments and things. Q1 is typically our strongest if you look historically because that's when you're collecting your Q4 receivables.

Ben Reitzes - UBS

All right, thank you.

Tony Takzawa

Thanks, Ben. Next question, please.

Operator

Thank you. Our next question comes from David Cahill with RBC Capital Markets.

Tom Curlin - RBC Capital Markets

Hi, it's Tom Curlin dialing in with Dave. A question on VMware and just longer-term M&A thoughts. There's been some comments in public forums about potentially fully spinning out VMware and it also seems like VMware can be a vehicle for some M&A activity for you guys over the next few years. How do you balance the conflict of a VMware that may be fully independent in a few years with respect to M&A ideas? What might be strategic to AMC on a stand-alone basis could also be strategic to VMware on a stand-alone basis?

Joe Tucci

Well, Tom, we have a very, very good Board, a very dedicated Board that is in place at VMware that we are going to continue to add world-class members to. And we will make sure that you stated it well, but I don't believe this is mutually exclusive at all. I think that we can have both companies and will have both companies prosper significantly. When we think of VMware we will take a long-term view of VMware. This is a phenomenal property with great potential and we want to make sure that we don't play this for just the short-term; we want to make sure this is set up for long-term success.

Tom Curlin - RBC Capital Markets

Do you agree that there may be some targets that are more appropriate for VMware to acquire versus EMC just given overall --?

Joe Tucci

Tom, look at it on (inaudible). If you own 87.5% of something or you own 100%, would you really think that differently.

Tom Curlin - RBC Capital Markets

It just depends on the direction of that mix in three or four years, right? If that's down to zero, right?

Joe Tucci

But we're here in the benefit of all our shareholders, the EMC shareholders own by definition 87.5% of VMware. And of course as the shares get distributed some of that will also end up in our shareholder base. So that common base will be pretty darn high and we're going to do the right things and we have the team in place to do that and the dedication to do that. We will think long-term for VMware and if it's best for VMware we'll make sure we do it there.

Tom Curlin - RBC Capital Markets

Okay, thank you.

Tony Takzawa

Thanks. Next question, please.

Operator

Thank you. Our next question comes from Glenn Hanus with Needham & Co.

Glenn Hanus - Needham & Co.

I'm getting some field reports of a little more aggressive pricing out in the core storage market, sort of the midmarket. Are you seeing that? Are you pricing a little more aggressively against Net Ap and some others or how would you sort of characterize the pricing environment and your strategies there going forward?

Joe Tucci

I've been in this industry now for seven years and it's always been aggressive. So I don't see any significant sea change here in the pricing environment. It's always been a tough environment, we have to always watch our cost, our supply chain and our margins. And I think if you look at our results, I think we're doing a fair job on all three and we will continue to do that. But I don't see any significant huge sea change out there. Is what I call the pricing environment competitive? I sure would. And has it been competitive for a long time? Absolutely.

Glenn Hanus - Needham & Co.

Thank you.

Tony Takzawa

Thanks, Glenn. We have time for one more question and then Joe will have a couple of closing comments.

Operator

Thank you. Our final question comes from Tony Sacconaghi with Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

Yes, thank you. I was wondering if you could comment on strength and profitability of the commercial space. Dell was 14% of revenues last quarter, 15.6 this quarter, that means its growth rate accelerated about 10 percentage points sequentially. I think you had mentioned that the real strength was in the commercial space. So could you give us a relative growth rate for your commercial channel including Dell?

And then, could you give us a sense for relative profitability? Because I think you said on a sequential basis margins went up because of the mix in hardware which I presume was a mix shift to CLARiiON because CLARiiON did so well this quarter. Obviously a lot of CLARiiON is through the commercial channel. So can you talk about each of those things, please?

Joe Tucci

I'll give you a little overall color, Tony. Certainly CLARiiON grew at 33%. We don't break this out, but for sure CLARiiON in the commercial segments grew faster than it did in the enterprise segment. So going down market has been a real success for EMC and of course our drive now is to go take that success we have in commercial and drive it. And the way we kind of broke up the market; the way -- everyone has their different way of doing it, but I've just got to take different cuts at the market.

So below commercial we have cut an SME, small and medium enterprises below SME. We've cut out small and medium businesses and we're driving down and so we're building out our channels and our support organization for both those SME, SMB markets as we speak. We're seeing great success, it's great opportunity ahead of us for EMC and I think for a long, long time. Whatever number we tell you about or talk about or achieve for mid-tier growth, the commercial space will be somewhat faster, we just don't do that breakout, Tony, but I gave you a little color.

And you're correct, at our average growth of 33% for CLARiiON, Dell was faster than that and other than that -- and David told you, it was mid-30s for growth. So year-on-year growth -- year-on-year, excuse me, percentage -- year-on-year growth was faster than the market average of 33%. So that's kind of all the color I want to give. I think you can draw your own conclusions from that. I think that's one of our great areas of potential as we go down market and we are very focused on that. And while we do that we're not going to take our eye off the ball in the high-end market either.

Toni Sacconaghi - Sanford Bernstein

In the margin side, can you comment on that?

Joe Tucci

What we've found is actually as we go into the commercial markets we are certainly -- I think there's actually opportunities to get higher margins. But we certainly don't see any difference in margins or any considerable difference between enterprise even though we do more channel. That would tell you at the customer level the margins are higher. Obviously in the enterprise we do almost all the selling ourselves. And of course we rely more through channels. But when you go look through the whole thing, I think there's more -- actually there's more margin opportunity the further down market we go, but right now they're both pretty good.

Toni Sacconaghi - Sanford Bernstein

Thank you.

Joe Tucci

I'd like to thank everybody for joining today and I'll kind of close with where the beat of my presentation was, that a company like EMC that views itself, and we are, a technology company. As you see now, we're spending over 12% of our revenues on research and development, that's the hallmark of technology companies. We're buying additional small, as I promised, tuck-in technology companies this year. So that's our investment and of course the fruits of that investment come in a really innovative good flow of products. And when I look at where we're positioned there for the second half of the year I am bullish on our future and I thank you very much for being with us today and see you in the future.

Operator

Thank you. This concludes today's teleconference. Thank you for your participation; you may disconnect at this time. Thank you.

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